Stone Energy Still Sinking

Stone Energy (NYSE:SGY) has nearly buried investors in bad news. In the past six months, it was forced to cut production because of Hurricanes Katrina and Rita; its proven reserves were twice revised downward; its filing of third-quarter results was delayed; financials back to 2001 have been restated (link opens PDF file); and the SEC launched an inquiry (PDF) into its practices. But I'm most surprised that all of this bad news has not caused these shares to become dirt cheap.

Perhaps the continued torrent of money into the oil patch has prevented Stone's shares from slipping further into cheapness. In Stone's release of fourth-quarter and fiscal 2005 earnings last Thursday, the company announced full-year earnings of $5.02 per share, even though annual production was down 5% because of the hurricanes.

With nearly 76% of its reserves in the Gulf of Mexico (with the remainder in the Rocky Mountains), the hurricanes had a severe negative impact on Stone's operations. During the second quarter (PDF), average daily production had increased to 285 MMcfe (million cubic feet of gas equivalent). The hurricanes knocked production down to 157 MMcfe in the fourth quarter, bringing average daily production for 2005 down to 228 MMcfe, compared to 241 MMcfe for 2004.

While the company was dealing with the hurricane damage, an internal review revealed major errors in reported reserves. Subsequently, official reserve estimates were revised downward (PDF) from 825 Bcfe (billion cubic feet of gas equivalent) to 670 Bcfe, which was revised even further downward to 593 Bcfe (PDF). That's a whopping 28% reduction from the initial figure. The bad news, beginning in early October of last year, sent shares spiraling downward and led to the SEC inquiry and financial restatements.

An independent review (PDF) into the situation revealed that company personnel "lacked adequate internal guidance or training on the SEC standard for estimating proved reserves," specifically the conservatism of the SEC's "reasonable certainty" standard for booking reserves.

With new procedures in place, and reserves restated at hopefully the correct level, have Stone Energy shares fallen into value territory? Let's see how Stone compares to a few Gulf of Mexico peers, based on enterprise value per Mcfe (thousand cubic feet of gas equivalent) of proven reserves:

At the current price of $39.40, Stone trades at about a 15% discount to its peers, and substantially below the price CalDive -- now Helix Energy Solutions (NASDAQ:HELX) -- paid for Remington Oil & Gas. Of course, pricing reserves is only one measure of valuation for oil & gas companies, but it does show that Stone's shares have fallen back in line with those of its peers, based on restated reserves.

I think the worst of the news has passed, but I'd only be interested in buying if the shares were really cheap. I'd be tempted if Stone's reserves were valued at $1.50/Mcfe -- around the price for which Vintage Petroleum, an onshore producer, was purchased last year by Occidental Petroleum (NYSE:OXY).

The independent review into the reserve restatement exposed a company that was making some amateur mistakes on the professional stage. If Stone can return to growing production and reserves, especially in deepwater Gulf of Mexico drilling, the shares will likely command a premium. That's a big "if." The smoke has not quite cleared from the recent debacle, and I'd prefer to see the company run without missteps for a few quarters before I start talking about upside.

For more petro-Foolishness:

• Cal Dive's Roughneck Love
• Alon USA Still Cheap
• A Few Nuggets Left in the Oil Patch

Fool contributor Robert Aronen has never restated his proven reserves and owns no shares of any company mentioned. The Motley Fool is investors writing for investors.